As of Friday, the S&P 500 was within 1% of its
upper Bollinger band at virtually every horizon, including daily, weekly and
monthly bands.The last time the S&P 500 reached a similar extreme was
Friday April 29, 2011, when I titled the following Monday's commentExtreme Conditions and
Typical Outcomes . I observed when the market has previously been overbought
to this extent, coupled with more general features of an "overvalued,
overbought, overbullish, rising yields syndrome", the average outcome has been
particularly hostile: .

"Examining this set of instances, it's clear that overvalued,
overbought, overbullish, rising-yields syndromes as extreme as we observe today
are even more important for their extended implications than they are for market
prospects over say, 3-6 months. Though there is a tendency toward abrupt market
plunges, the initial market losses in 1972 and 2007 were recovered over a period
of several months before second signal emerged, followed by a major market
decline. Despite the variability in short-term outcomes, and even the tendency
for the market to advance by several percent after the syndrome emerges, the
overall implications are clearly negative on the basis of average return/risk
outcomes."

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As it happened, April 29, 2011turned out to mark the exact
high of the S&P 500 for the year, and was followed by a steepintermediate
market plunge.My impression is that despite the recent run of speculation the
market has enjoyed - largely reflecting a reprieve in European debt concerns and
what appears to be a drawing-forward of jobs into the first quarter due to
unseasonably favorable weather - the extended implications of present market
conditions remain decidedlynegative.

.

If you examine the components of the S&P 500
individually, you'll quickly find that the majority of those stocks are also at
or through their own upper Bollinger bands.In overvalued, overbought,
overbullish, rising-yield conditions, those extensions are often resolved in
unison, which is what produces the characteristic "air pocket" where the index
can give up weeks or sometimes months of upside progress in a handful of
sessions (though we often see a knee-jerk reaction to buy that initial dip
before more serious follow-through occurs).

.

In recent weeks, the market has faced what I've called an
"angry army of Aunt Minnies" (see for example Warning: A New Who's Who of
Awful Times to Invest and Goat Rodeo), These are
indicator syndromes that are generally (and sometimes singularly) followed by
steeply negative market outcomes.When I present these in the weekly comments,
I'll often give specific thresholds (such as a Shiller PE of 18, 27%bearish
sentiment, and so forth) in order to give an idea of where the "border" of a
given cluster of data tends to be, but these aren't magic numbers. The objective
is to capture a syndromeof conditions that is characteristic of some
particular diagnosis, but the outcomes are generally robust to small variations
in how they are defined. For example, with as fewbears as we haveat present,
there's little distinction between say, 45%bulls and 44% bulls. As I noted last
May:

.

"We can define an 'overvalued, overbought, overbullish,
rising-yields syndrome' a number of ways.The more general the criteria, the
better you capture historical instances that preceded abrupt market weakness,
but the more you also encounter'false positives.' Still, as long as the
criteria capture the basic syndrome, we find that the average return/riskprofile for subsequent market performance is negative, almost regardless of the
subset of history you inspect."

.

The steepest market plunges on record (e.g. those following
the 1973-74, 1987, 2000 and 2007 peaks, among others) have generally followed an
overvalued speculative blowoff coupled with divergent interest rate pressures.This is why we take the "overvalued, overbought, overbullish, rising yields"
syndromeso seriously. Indeed, the outcomes are usually negative on average even
without rising yields, but the yield pressurestend to add immediacy. Notably,
the emergence of this syndrome has provided accurate warning of on coming losses
both historically, and also as recently as 2010 and 2011.

.

These syndromes are useful because the combinationof several conditions often carries far more information than any of them
individually.To ignore syndromes like the ones we've increasingly observed in
recent weeks is like having nausea, sudden lower-right abdominal pain -
especially following a period of dull pain in the upper abdomen, coupled with an
inability to even consider jumping, and shrugging it off as a stomach
ache instead of recognizing that, in all likelihood, your appendix has just
burst.

.

Two concepts of risk - market risk and tracking
risk

.

Our approach has always been to accept the risk of market
fluctuations in proportion to the average return that we can expectper
unit of risk, given prevailing market and economic conditions.So we are willing
to take a higher exposure to market risk when the prospective return/risk
profile is favorable (as it was in 2003 for example). In contrast, we limit our
exposure when the profile is weak, and hedge very tightly against market risk
when we are confronted with classic signs that have almost invariably precededmajor market setbacks (such as the "overvalued, overbought, overbullish,
rising-yields" syndrome we observe today). That word "average" is important -
our exposure to market risk tends to be proportional to theaverage
return that we expect from that risk, given market conditions. From a
full-cycle investment perspective, this is actually optimal strategy.

.

From a psychological perspective, however, it may
not be.Specifically, we've had a number of conversations with shareholders of
the following form: "I know that the indicators you're looking at are negative,
and I do agree that eventually we'll see a bear market that wipes out a lot of
these market gains, but here and now, the market is going up. Can't you take a
larger exposure to market risk - not huge - but enough to participate a little
bit until things turn down?" The basicanswer is, yes we could, but we know from
historical evidence that we would not actually expect to addto our net
returns over time.

.

Instead, we might gain some amount in the event that the
market was to advance further, but we would also expect to lose that amountwithout any predictable expectation of "locking it in." This is because we would
be taking a positive position despitenegative expected returns, so there would
then be no trigger to sell except at the point where a new downtrend
was already established, most likely at similar or lower prices, and very
possibly on a large and abrupt decline where good price execution would be
difficult.

.

Still, I recognize that this sort of strategy might be
psychologically preferable to some investors - despite not adding
anything to long-term returns.Participating some amount during an advance might
simply feel better, even if there is no expectation of actually
retaining that short-term gain. This is an important issue because it highlights
the difference between twokinds of risk - onebeing market risk itself, and onebeing tracking risk (the difference between one's own performance and
the performance of the market).

.

Our own investment strategy places very little weight on
tracking risk, because we are focused on the complete bull-bear market cycle.Likewise, we don't particularly care whether we take our drawdowns during
periods when the market is rising or when it is falling, provided that those
drawdowns are relatively muted over the full cycle (particularly compared with
the losses of over50% that the stock market has periodically experienced).
Indeed, from a diversification perspective, it's better for us to take our
drawdowns when the major indices are not, and vice versa. Accordingly, if a
given amount of risk isn't expected - on average - to have a positive return,
given prevailing market conditions, we simply don't take it. Yet it's clear,
especially at times like these, how uncomfortable it can be psychologically to
be defensive during an exuberant rally.

.

While I am convinced - even adamant - that the present time
would be the wrong moment to make any shift toward greater market risk, I do
understand the psychological discomfort that tracking risk can create. Reducing
tracking risk involves a tradeoff - you tend to move somewhat morein line with
the market, but you also tend to experience more frequent drawdowns. It's very
difficult to exit with further gains once the average return/riskprofile goes
negative - even if various trend-following measures are still positive. We're
open to refinements in our approach that might reduce tracking risk somewhat -
provided that we don't materially increase large drawdowns, or reduce expected
long-term returns in the process. But our main objective is always focused on
investment returns over the complete market cycle (bull market plus bear market)
with significantly smaller periodiclosses than a buy-and-holdapproach. Within
the limits of that objective, we'll work to findways to diminish the periodic
discomfort we ask our shareholders to accept. Again however, I am convinced that
now would be precisely the wrong time to give in to that discomfort by accepting
greater market exposure.

.

On the subject of investment performance over the complete
market cycle (bull peak to bull peak, bear trough to bear trough), a few
observations may be useful.In the Strategic Growth Fund , we view the period
from the 2000 market peak to the 2007 market peak (peak-to-peak), and the period
from the 2002 market trough to the 2008-2009 market trough (trough-to-trough),
as fairly representative of typical full-cycle application of our investment
approach. In these complete market cycles, the Fund widely outperformed the
S&P 500, with far smaller periodic losses.

.

As we've discussed in previous weekly comments, annual
reports, and briefly below, the 2009-early 2010 period was notably
unrepresentativeof our typical investment strategy.Unfortunately, as
a result of that period, the total return of the Fund from the 2007 market peak
(10/9/07) through Friday's peak is - at least temporarily - a cumulative 11.6%behind the S&P 500, though we've experienced muchless volatility and far
smaller intervening losses.

.

The simple fact is this. Despite anticipating much of the
financial crisis and the accompanying market losses, I misjudged the likely
policy response, expecting what I called a "writeoff recession" where reckless
lenders would be expected to take losses, rather than a "kick the can" approach
- defending bondholders at public expense, changing accounting rules, and
mounting massive central bank interventions, all of which promise to create
recurring crises for years to come (see the Swedish banking crisis in the 1990's
for an example of a proper and durable response). As the crisis deepened, I
insisted on stress-testing our hedging approach, with the requirement that it
should perform well in validation data from both post-war and Depression-era
periods. There was simply no way to "average in" Depression-era evidence without
getting consistently negativeexpected return/risk estimates.

.

Indeed, during the
Depression, the same valuations that we saw at the 2009 lowswere
followed by a further loss of two-thirds of the market's value. Until I
was certain that our methods were robust to both data sets, we remained hedged.

.

We ultimately tackled that "two data sets" problem with
ensemble methods, which capture distinctions that we were frankly unable to make
without them.We were very open about the challenges we faced during 2009 and
early-2010 in solving that problem, because the need to properly integrate
Depression-eradata forced a defensive stance that was not representative of our
"typical" investment strategy. In short, the 2009 - early 2010period is
distinct in that it isnot indicative of the hedge position that can be expected
of our strategy in future marketcycles, even under identical conditions and
evidence.

.

These considerations may go some way in understanding why the
Strategic Growth Fund remains my largest single investment holding (with nearly
all of my remaining liquid assets invested in the other threeHussman Funds).

.

The S&P 500 has underperformed Treasury bills for what is
now a 13 yearperiod, and we certainly expect that future cycles will feature
more historically normalvaluations and prospective market returns. In that sort
of environment, we would expect to take far more aggressive investment positions
than we've been able to take since 2000. That said, our investment actions from
2000 through 2008, as well as our actions since early 2010, are representative
of what we could beexpected to do again under identical conditions and
evidence.

.

Frankly, thisincludesthe fact that our investment
stance has been largely defensive since early 2010. In that regard, it's notable
that the S&P 500 gained no net ground from April 2010 through November of
2011. Of course, the market has advanced significantly in the past few months.
Our defensiveness in theserecent months has been driven by overlapping
syndromes of historically negative evidence, with increasingly extreme warningflags. The day-to-day discomfort that we experience here - being defensive in an
overvalued, overbought, overbullish advance where various warning flags abound -
may be frustrating, but is fairly typical of what our investment strategy will
experience in similar conditions, as we did in 2000, 2007, and prior to the less
severe 2010 and 2011 declines.

.

Undoubtedly, our recent defensiveness would feel less
uncomfortable had I realized that we would be forced to contemplateDepression-era data, and had our current ensemble methods been in place to
capture significant gains during that2009 - early 2010period. It's clearly my
job to minimize or eliminate the impact of that "miss" over the present cycle.
Again, however, I remain adamant that now would be one of the worst possible
times to acceptmarket risk in hopes of "catching up" - when valuations are rich
instead of reasonable, prices are strenuously overbought instead of oversold,
investor sentiment is exuberant rather than fearful, the growing technical
divergences are negative rather than positive, corporate insiders are
frantically selling instead of buying, stocks are grasping at speculative highs
instead of multi-year lows, and risk premiums are razor-thin instead of
satisfactory.

.

Economic Notes

.

On the economy, our broad view is based on dozens of
indicators and multiple methods, and the overall picture is much better
described as a modest rebound within still-fragile conditions, rather than a
recovery or a clear expansion.The optimism of the economic consensus seems to
largely reflect an over-extrapolation of weather-induced boosts to coincident
and lagging economic indicators -- particularly jobs data. Recall that seasonal
adjustments in the winter months presume significant layoffs in the retail
sector and slow hiring elsewhere, and therefore add back "phantom" jobs to
compensate. While my remarks on seasonal adjustment have been co-opted by a few
conservative blogs, I don't view these adjustments as manipulative. It's just
important to understand their impact. It seems likely that particularly in
retail and construction, favorable weather has brought forward hiring that would
normally occur in the spring months, and the seasonal adjustment factors have
added to those anyway. The question - still unresolved - is whether the jobs
brought forward from the springmonths will take anything out of the job
creation numbers we see in the months ahead, particularly in the April-May time
frame.

There's slightly more dispersion in various economic Aunt
Minnies we track, but the overall picture is mixed at best.On the side of
concern is a syndrome that uses the standardized values (zeromean, unit
variance) of the OECDUS, OECD Total, and ECRI Weeklyleading indices. A strong
discriminator of actual recessions and recoveries can be defined as follows:
When all three are below-0.4, and the average is less than-1, the economy has
always beenapproaching or in recession.

.

Conversely, when at leasttwo of thesethreeimprove to -0.2 or better, the economy has always been entering a
recovery. It's possible to vary the criteria slightly (e.g. 0.1tighter or
looser), but that seems to invite some false positives or false negatives,
particularly due to data revisions. This is still onlyone measure, and as such
should beused as a rule of thumb in the context of dozens of other
indicators (which is how we use itin practice). Still, it's an instructive
example of the coordinated indicator movements we try to capture with
Aunt Minnies.

.

The OECD leading indices were released again last week, as was the
latest reading in the ECRI index.The standardized values of allthreeremain
below -0.2. That may change in the weeks ahead, but we have not seen it yet. An
improvement on this Aunt Minnie would be helpful in alleviating the concern we
presently have about leading indicators, particularly if we see somestrength in
real consumer spending as well.

.

Here's what this particular Aunt Minnie looks like (shown by
the regions outlined in red).Actual US recessions are shaded blue. The most
recent data would not trigger this syndrome today, but it does not relieve the
existing signaleither. Our best interpretation is that the leading data is
mixed - not deterioratingat present, but certainly not "all clear" yet.

.

.

On the brighter side, the recent speculative run does give us
fewerrecession warning signs from financial market variables like stock prices
and credit spreads.Recessions tend to be associated with stock price weakness,
widening credit spreads, a reasonably flat yield curve, and fairly tepid ISM
readings, among other factors. Generally speaking, we use a 6-monthlook-back
(again, not a magic number, but simply a way to make the syndrome operational).
Presently, credit spreads would have to widen by about40 basis points and the
S&P 500 would have to decline by about15% in order to re-establish this
particular syndrome of recession warning conditions, which we observed last
summer. Given the unusually extreme stock market conditions and narrow risk
premiums here, I certainly wouldn't rule out fresh deterioration in the S&P
500 and corporate debt. But for now, suffice it to say that despite continued
concerns from leading economic measures, financial variables would have to
deteriorate in order to confirm those concerns more unanimously.

.

Market Climate

As of last week, the Market Climate for stocks remained
characterized by an unusually hostile set of overvalued, overbought,
overbullish, rising-yield conditions.The record of steeply negative market
outcomes that have followed these conditions has nothing to do with myopinionbut instead reflectsobjective historical evidence. The outcome
in this particular instance may be different, and we have no problem
with investors who are willing to invest on that expectation. We are not. It's
that simple.

.

At present, we estimate the likely total return for the
S&P 500 over the coming decade to be about4.1%annually (nominal). While
this may seem adequate compared to a 10-year Treasury yield of 2.3%, the
comparison entirely ignores risk. You don't just "lock in" a 10-yearreturn -
you ride it out. The volatility of stocks is dramatically higher than the
volatility of a 10-year bond. So the proper question is not whether stocks are
priced to achieve a greater10-yearreturn than bonds, but what happens if
investors eventually demand evenmodestly higher prospective returns.
The answer is that the impact of changes in valuation multiples would swamp any
reasonable expectation for growth in fundamentals. Satisfactory returns on
stocks now require strong assumptions for GDP growth (about 6%nominal
annual growth) and sustained profit margins (presently over 60%above the
historical norm), in addition to the requirement that valuations remain rich and
prospective returns stay indefinitely depressed. This may occur over the short
run, but beyond that it strikes us as pure speculation.

.

.

Strategic Growth Fund and Strategic International Fund remain
fully hedged here. About 50% of the holdings in Strategic Dividend Value are
presently hedged - which is the Fund's most defensive stance. In Strategic
Growth, our avoidance of "high beta" financial stocks, coupled with some option
price decay in our higher-strike puts, does create a moderate tendency for the
Fund to move inversely to the market - especially during "risk on" days when
financials lead.

.

Given that option volatilities have retreated and we have not
been aggressive in raising our put option strike prices, that tendency has
declined a bit in recent weeks. Moreover, our stock holdings have a strong
record of outperforming the major indicesover time, so we remain comfortable
with our avoidance of certain sectors. Our present investment position is
well-aligned with the return/riskprofileimplied by the market evidence here,
but we'll continue to take opportunities to mute the effect of "risk on"
speculationwhenever possible. In the meantime, I expect our present sensitivity
to these periodic spikes to more a short-termnuisance than a longer-term
feature of our investment stance.

.

In Strategic Total Return, our precious metals position
remains at less than3% of assets, as the defensive shift we saw in the Market
Climate has persisted despite the recent price weakness.Likewise, we cut back
our duration weeks ago in our Treasury holdings, currently to about3.5 years.
While we would expectTreasury bonds to rebound considerably on any fresh
economic deterioration, our present duration is adequate from the standpoint of
present evidence - the expected return/risk estimates from our ensembles have
not rebounded much despite the recent increase in yields. Overall then, we are
maintaining fairly modest risk exposure here across the board.

The Bailout Bias

19 March 2012

Leszek Balcerowicz

WARSAW – The seemingly never-ending debate over the eurozone’s fiscal problems has focused excessively on official bailouts, in particular the proposed purchase of government bonds on a massive scale by the European Central Bank. Indeed, we are warned almost daily – by the International Monetary Fund and others – that if bailout efforts are not greatly expanded, the euro will perish.

For some, this stance reflects the benefits that they would gain from such purchases; for others, it reflects mistaken beliefs.Creditors obviously support bailing out debtor countries to protect themselves. Many political leaders also welcome official crisis lending, which can ease market pressure on them. The media, meanwhile, always thrives on being the bearers of bad news.

Mistaken beliefs, on the other hand, are reflected in metaphors like “contagion” and “domino effect,” which imply that financial markets become blind, virulent, and indiscriminate when they are disturbed.Such terms provoke fear that, once confidencein any one country is lost, allothers are in danger.

According to this logic, it follows that only a formidable countervailing power – such as massive official intervention – can halt the ravenous dynamics of financial markets.Widespread use of expressions like “aim a bazooka at the eurozone,” and “it’s them or us,” demonstrates a pervasive Manichean view of financial-marketbehavior vis-à-vis governments.

But financial markets, even when agitated, are not blind. They are capable of distinguishing, however imperfectly and belatedly, between macroeconomic conditions in various countries. This is whyinterest-rate spreads within the eurozone have been widening, with Germany and the Nordic countriesbenefiting from lower borrowingcosts and the “problem” countries being punished by a high-risk premium.

Another, related, fallacy is the assumption that reforms can reap benefits only in the long run.This misconception reduces the short-term solution to affected governments’ sharply higherborrowing costs to bailouts. In fact, properly structured reforms have both short- and long-term effects.

For example, one does not need to wait for the completion of a pension reform to see reduced yields on government bonds.Markets react to credible announcements of reforms, as well as to their implementation.

The countries that have been severely affected by the financial crisis illustrate the impact of reform.One group – Bulgaria, Estonia, Latvia, and Lithuania (BELL) – experienced a surge in yields on their government bonds in 2009, followed by a sharp decline. Another group – Portugal, Ireland, Italy, Greece, and Spain (PIIGS) – has had more mixedoutcomes: yields have soared on Greek and Portuguese bonds, while Ireland’s were falling until recently.

These differences can be explainedlargely by the variations in the extent and structure of these countries’ reforms. Proper reforms can produce confidence and growth. Official crisis lending can buy time to prepare, and it can help to stop a banking-sector crisis, but it cannot substitute for reform.

All bailouts can create moral hazard, because they weaken the incentive to implement reforms that will avoid bad outcomes in the future.To some extent, official crisis lending replaces the pressure from financial markets with pressure from experts and creditor countries’ politicians.

Among the proposed eurozone bailouts, none has come under the spotlight as much as the idea that the ECB should purchase massive quantities of the problem countries’ bonds. Advocates of this approach stretch the concept of “lender of last resort” to suggest that providing liquidity to commercial banks is the same as funding governments. They also present the alternative to a bailout as a “catastrophe.”

Finally, they cite similarpolicies implemented by the United States Federal Reserve, the Bank of England, and the Bank of Japan – as though merely mentioning past examples is evidence that ECB lending will work.

These rhetorical devices must not overshadow careful analysis of the various options.There has been surprisingly little comparative analysis of the effects of quantitative easing (QE) in Japan, the US, and Britain. Yet the evidence indicates that QE is no free lunch. Although it may offerpotential benefits in the short run, costs and risks invariably emerge later.

In Japan, QE may have contributed to delays in economic reform and restructuring, thereby weakening longer-term economic growth and exacerbating fiscal distress.In the US, it failed to avert the slowdown during 2008-2011, while America’s 2011 inflation figures may turn out to be higher than they were in 2007. In Britain, economic growth is even slower, while inflation is much higher. And these countries’ QE has also fueled asset bubbles in the world economy.

Massive purchases of government bonds by the ECB would be the worst type of bailout.The fact that such purchases are potentially unlimited would exacerbate the problem of moral hazard. It would also increase the risk of inflation, along with other negative economicconsequences.

Moreover, such a bailout could undermine the ECB’s trustworthiness as guardian of the euro’s stability, particularly in light of the new political power that it would obtain.And it would further undermine the rule of law in the EU at a time when confidence in the Union’s governing treaties is already fragile.

The key to resolving the eurozonecrisis lies in properly structuredreforms in the ailing countries.Indeed, experience shows that there is no substitute.

If you know the other and know yourself, you need not fear the result of a hundred battles.

Sun Tzu

We are travelers on a cosmic journey, stardust, swirling and dancing in the eddies and whirlpools of infinity. Life is eternal. We have stopped for a moment to encounter each other, to meet, to love, to share.This is a precious moment. It is a little parenthesis in eternity.